Friday, June 30, 2017

I've been meaning to try this for some time, and finally got around to it. This is a motion scatterplot of over 10,000 zip codes from 2000 to 2017, showing how home prices changed through the various stages of the boom and bust. The measure on the x-axis is median zip code home price. The measure on the y-axis is the 6 month change in zip code median home price (not annualized, continuously compounded). I have highlighted LA, New York City, and Phoenix. (Data from Zillow.)

Closed Access Price Appreciation:

Until late 2003, prices within each MSA tended to rise as a group, and prices in the more expensive MSAs were rising more. This is the fundamental Closed Access problem. Expensive cities were becoming more expensive.

Subprime Boom:

Around the end of 2003, we start to see the transition away from the GSEs to the private mortgage securitizations (subprime and Alt. A). This shift was stronger on the west coast, and we can see here how there is a separation between LA and New York. Note that initially, LA prices increased as a group. There still was little difference in top and bottom tier housing markets. Also, there was little impact in Phoenix at this time. And, we can see that the effect of the shift to private securitizations was to increase prices in the high cost cities. The trendline for the aggregate national plot becomes very steep during this phase. This is because the looser terms of the private securitizations were facilitating home purchases in Closed Access cities by households with high incomes.

Rate Hikes & Subprime Boom:

Fed rate hikes began soon after the private securitization boom began, in June 2004. As the Fed Funds rate increased, the main effect was a decline in top tier price appreciation in LA. So, during this period, from mid 2004 to late 2005, there was a big difference between low tier price appreciation and high tier price appreciation in some cities, but in LA, this is because all home prices were rising sharply in 2004, and then high tier price appreciation retreated after the Fed began to raise rates. It was after the retreat of high tier price appreciation in LA that prices in Phoenix finally shot up.

Now, maybe this is a just-so story. But, I think this is a case where thinking of Fed policy in terms of interest rates is problematic. I think we are seeing three separate effects here. First, as rates continued to rise, migration out of Closed Access cities was very high - for both renters and owners. NGDP growth was starting to moderate. Homeownership had peaked and was starting to decline. And, sentiment was starting to turn south in the housing market, partly because of these factors. This was leading to tactical selling and outmigration of homeowners. At the peak, which was during this time, about 2% of Closed Access homeowners were moving out of the Closed Access cities annually, net of in-migration. That is a significant amount of selling pressure, and I think this is a major factor in the downshift of price appreciation during this time. And, a lot of that pressure was from households with significant equity positions who had owned their homes for a long time. It appears that there were a lot of families whose home values were far out of scale with their general income and wealth, and they captured the capital gains as the boom peaked. These appear to have generally been households that aren't particularly leveraged. So these sales weren't particularly interest rate sensitive. They were more sensitive to sentiment and expectations.

Second, in the low tier markets in LA, the private securitization market was still the dominant factor. It was still funding starter homes in Closed Access cities, although by 2005, the flow of first time homebuyers was starting to decline. But, it appears that aspirational buyers were still entering the housing market at this time in LA. Again, this was probably not activity that was particularly rate sensitive. These loans tend to have higher rates than conventional loans. And, the Fed Funds rate doesn't necessarily have that strong of an influence on long term mortgage rates. It definitely didn't during this period. This lending channel remained strong because it wasn't that sensitive to the Fed Funds rate.

Third, the combination of tactical sellers and priced-out renters both led to a massive outflow of population into cities like Phoenix, and that is the main factor behind Phoenix's late price surge. Certainly this price surge was also facilitated by the loose terms of the private securitization boom, both for first time buyers and for investors. But, I think migration explains the timing of these events - why the Phoenix surge was so late in the boom and why it occurred after LA price appreciation had already started to wane. This is also not related directly to interest rates, which is made clear by the fact that the entire boom in Phoenix happened after the Fed began to raise rates.

So, I don't think interest rates, per se, have much to do with these trends. Money supply and expectations seem more important.

Inverted Yield Curve & Subprime Boom:

When the yield curve inverted in late 2005, which is an important signal of financial dislocation and coming economic contraction, we see an immediate and sharp reaction in all markets. Really, this should have been the extent of the contraction. By the time the CDO panic, there had been a significant amount of monetary tightening. The yield curve had been inverted for nearly two years with predictable results - declining NGDP growth, declining housing starts and investments, moderating or falling prices, the initial drop in employment growth.

By the end of this period, home prices were beginning to decline, but this decline was led by the top end, both locally and nationally. Within MSAs, it was high tier markets that tended to fall into declining territory first. And, nationally, we can see the trendline start to fall below 0%, and it has a negative slope when it does.

CDO Panic

By the time of the CDO panic around August 2007, the private securitization market was dead, and the other mortgage conduits didn't expand to take up the slack. Since private securitizations had been facilitating entry into Closed Access housing markets, at a national level, the drop in demand was most felt in the expensive cities, so at a national scale, it was expensive markets that dropped the most. The national trendline really goes negative. But, within those cities, it was the low tier entry markets that had large numbers of recent new buyers with large mortgages who were vulnerable to default and who were now locked out of mortgage access. Even though they were in entry markets, this was largely young families with high incomes. We can infer this because the initial drop in homeownership during this time was among young families with high incomes.

GSE Conservatorship & Financial Crisis

Here we can see how these low tier markets continued to drop for months or years after the GSEs were taken over, while top tier markets stabilized. We can see this in both axes. First, we see the long tails down to the left that represent low tier markets that, even in 2009 were declining by 10% or 20% or more, every six months. And, this is such an extreme drop, we can see those dots moving left over this time, as the median prices in those zip codes were decimated.

Buyers in these markets were locked out of mortgage markets by the tight lending standards of the GSEs. This period and after was when the vast majority of defaults happened. Really, by the CDO panic of late 2007, nominal home price changes at the national level were in unusual negative territory. The declines between then and September 2008 were gut wrenching and far outside of any modern experience. And, after that happened housing markets at the low end continued to experience losses for years, that, by themselves, would have registered as generation defining events. Any relative valuation gains during the boom had been reversed by now. In most cities, like Phoenix, there had never been any unusual gains in the low tier compared to the high tier, but the low tier losses after 2008 are massive. (edit: You can really see this by just watching the Phoenix zip codes over the entire period. High tier markets tend to lead low tier markets, slightly, in both boom and bust, but there is never much difference between high and low tier markets during the boom. There is an idea that the bust was just the rewinding of the boom. But, in Phoenix, a true unwinding would have effected all zip codes equally. This wasn't an unwinding. This was a massive dislocation targeted at low tier markets.)

Dodd-Frank

That wasn't enough for us, though, and in July 2010, we passed Dodd-Frank. And, with its passage in this time lapse graph, we can see the market that was just finally starting to stabilize take another pause. The declines by this time were not as sharp as they had been in late 2008 and 2009, but we can see low tier home prices stall with continued price declines for another couple of years after that. There were significant valuation discounts in those markets by then. There was absolutely no reason to restrict lending and demand in those markets. The rate of first time home buyers had been very low for years by then. If anything, there had been a deficit of lending at the margin. And this is not a subtle point. The lack of reasonable lending in low tier and entry markets had been extreme. Finally, in 2012, prices ceased their decline. (edit: You can see this by focusing on the national trendline. It was just starting to move back up to zero when Dodd-Frank was passed, and just as Dodd-Frank passed, the left end of the trendline moved back down, and didn't recover back to zero until 2012.)

Wednesday, June 28, 2017

This first one gives an indication of the "house as entry fee" phenomenon in the Closed Access cities. This is a graph of the average home value, by owner income. Most first and second quintile owners are older owners who bought their homes many years ago, so values are generally flat across the low quintiles. Values tend to rise starting with the third quintile, increasing with each quintile....except for the Closed Access cities.

In the Closed Access cities, homes are toll gates to labor markets, and it appears that now, that toll is about $400,000. So, owners across the bottom 80% of the income distribution all own homes with average values of about $400,000. It is only households in the top quintile who are willing, in the aggregate, to spend more than the toll value for more shelter.

________________________

The next graphs get at the issue of age. The bust was largely a bust among young people. This is a point of disagreement I have with Mian and Sufi. They paint this as a story of rich vs. poor. Rich households are savers and poor households are borrowers. This is kind of true. But, as JW Mason pointed out in the paper I linked to yesterday, this net debt distribution hides a lot of stuff going on at the gross level. Actually, most debt is held by households with high incomes, and households with middle-to-high incomes tend to be the most leveraged.

More importantly, in terms of wealth, age is at least as important as income. Older households tend to have high net worth and younger households tend to have low net worth. We especially see this in the housing market, where young owners tend to be very highly leveraged and older owners tend to be unencumbered or lightly leveraged. This is the overwhelming pattern in housing markets, and it did not shift during the housing boom. There was an increase of young owners - mostly young households with high incomes - so, broadly speaking, older owners were either selling and claiming their capital gains or were sitting on homes with rising equity values and falling leverage, and there was somewhat of an influx of younger owners, who naturally initiate ownership with higher leverage.

In 2006 and 2007, the nation's newspapers were filled with stories of crazed speculators leveraging up homes to flip them, or families in financial distress using home equity to get by, or families recklessly using home equity to over-consume. Those anecdotes just don't add up to much. The American housing market is a Cape-size shipping vessel of enduring lifecycle trends, and all these anecdotes of excess and speculation were just so many barnacles that can't amount to much. Tens of millions of older Americans own lightly encumbered homes and it would be mathematically implausible for tactical borrowers and speculators to amount to anything close to that in terms of market influence. This is confirmed by the Survey of Consumer Finance, where leverage levels by age were generally stable until equity levels collapsed.

Anyway, back to Mian and Sufi, what this means is that the bust was not about rich vs. poor, but it was about old vs. young, and we can see in these graphs how home ownership among 55-65 year olds was largely unaffected by the housing bust. That is because those owners have very high levels of equity. Ownership of households over 65 years has actually risen.

Owners below 45 years of age, however, have been devastated. Notice, also, that the decline in ownership is fairly proportional across incomes. Some of this is from foreclosures and some of it is from a post-recession mortgage market that is stifling new ownership. As a broad first estimate, we might consider the decline in ownership in the Open Access cities to be composed somewhat of foreclosures, but to mostly reflect limited mortgage access. The deeper declines in the Closed Access and Contagion cities are likely mostly a reflection of higher foreclosures.

Monday, June 26, 2017

J.W. Mason at John Jay College, City University of New York, who blogs at the Slack Wire posted an outstanding paper in progress (paper is 2nd link in the linked blogpost) about debt, consumption, and business cycles - specifically the Great Recession. He really gets at many of the problems with conventional ways of talking about these things that I have been grappling with, and he addresses them at depth and with new data.

He complains about the standard treatment of aggregate debt as if it is consumer debt. On the idea that income inequality led to debt-fueled unsustainable consumption:

(H)ousehold debt varies positively
with household income; low-income households report very little debt. Mortgages,
student loans, and to some extent auto loans, are specifically middle-income phenomena.
Peak debt-income ratios are found near the high end of the income distribution,
between the 75th and 90th percentile by income. Absolute debt levels rise
monotonically with income. The most natural result of a more unequal distribution
of income, therefore, would be a fall in household debt. Poor households do not
own the assets for which most debt is incurred, and rich households can buy them
outright...More generally, the fact that debt
is primarily incurred to finance asset ownership, not current consumption, must be
the starting point for any discussion of household debt.

He also notes that all of the increase in household consumption in the decades before the Great Recession was from third party and imputed expenditures (public health care, employer health care, imputed owner-occupier rents, etc.) There was no aggregate rise in relative consumption expenditures. He notes:

(T)o the extent consumption trends have diverged from income trends, it has been in
the direction of higher consumption as a share of income among high-income households,
and lower consumption relative to income among lower-income households.
If a mechanism is needed to explain rising consumption demand in the face of more
unequal income in the period before 2007, it should focus on luxury consumption
among the rich - perhaps driven by a wealth effect from capital gains - rather than
on debt-financed consumption among the bottom 95 percent.

Driven by capital gains. Most studies find that consumption inequality has increased by more than income inequality. (And, we know why: Closed Access homeowners are spending their economic rents.)

Mason comments, "As people
get poorer, they don't borrow more, they buy less. This decline in living standards
among lower-income households is reflected in many indicators of health and wellbeing,
such as falling life expectancies. (Case and Deaton, 2015) It is strange that so
many of these writers implicitly deny that income inequality has led to falling living
standards for poor and working class households, but instead has been cushioned by borrowing." I also think it's strange that a nation supposedly increasingly floundering in consumer debt would subsequently engage in a bidding war on the most durable middle class asset class.

As with so many of these papers, I must swoop in and replace his conclusion with my own, using my alternative version of the housing boom. My conclusion would begin with one additional point, which is that rising home values were the result of rising rents in constrained cities, and that capital gains on those homes were capitalized economic rents. There is nothing unsustainable about those gains as long as we continue to limit entry into our productive core urban centers. The reason for the trends Mason finds can be very broadly explained with three groups of households. Legacy Closed Access real estate owners that can realize capital gains and use them for consumption, young highly skilled professionals who had taken out large mortgages to gain access to those Closed Access labor markets and incomes, and households throughout the country with lower incomes who are locked out of those labor markets and who did not take on more debt because they weren't bidding on Closed Access real estate. Those households have stagnant incomes and consumption growth.

I especially appreciate seeing Mason's treatment of debt, cyclically. The vast amount of debt is a claim on an asset, not consumption debt. Equity and debt are two forms of ownership. Equating the shift of ownership from equity ownership toward debt ownership with some sort of recklessness or unsecured debt-fueled consumption leads, in my view, to an incoherent view of debt and business cycles, and I think Mason gets at the root of that problem here.

Here is an article at reason.com about how occupational licensing keeps former criminals from getting work after they are released.

Consider these two proposals:

1) To protect consumers, felons should be prevented from getting occupational licenses.

2) To protect workers, employers should be prevented from asking about criminal records.

Isn't it funny how these are both popular positions, yet they are contradictory? There are many places where both of these policies are in place. The reason they are both in place is because politics, at its base, is about status, not about outcomes. Consumers beat producers. Employees beat producers. What about employees and consumers? That is just a relationship that we don't regulate. Indirectly, licensing is a constraint on consumers. You can't hire who you want to hire for a job. But, the decision point is made at the point of the person becoming a professional, not at the point of sale, so in practice, we generally don't experience this constraint directly, as consumers.

If we thought about that relationship, it would force us to come to terms with some of our unconscious motivations. Should it be illegal for a couple planning a wedding to discriminate against a gay baker? Should it be illegal for a plumber to refuse to work for a jewish employer? Should it be illegal for a family to disown their daughter for marrying a Muslim man? Should it be illegal for that daughter to consider race, creed, ethnicity, or religion when she chooses a husband?

On this, I feel a bit like Richard Dawkins when he said, "“We are all atheists about most of the gods that humanity has ever believed in. Some of us just go one god further.”

We are all extremists about the liberty to be outrageously discriminatory and prejudiced in our private actions. Some of us just go one private act further. If you wonder how anyone can be so heartless to let employers and producers discriminate against employees and customers, you really don't need to look beyond your own conscience and the countless private acts of discrimination that you have never even remotely thought to regulate.

Think of the difference in how we react, even to the words. If we say that the financial crisis was due to deregulation, and that we need to enact new regulations to keep banks on the right path, this seems so obviously true that it is almost an aphorism. Of course regulating something is a net benefit. The first dictionary definition is "control or maintain the rate or speed of (a machine or process) so that it operates properly." But, think of how differently we react to, "Our deregulated marriage system has such a high failure rate. We need to regulate marriages." "So many kids are not served well by our deregulated classrooms. We need a comprehensive set of teacher regulations to force teachers to work for the benefit of all of their students." "Studies overwhelmingly show that time spent reading and speaking with children has huge benefits. Our deregulated family system has failed us. We need comprehensive regulations about the time and activities that parents engage in with their children."

Our different reactions to these regulations has nothing to do with our needs or with their potential for good. It has to do with which identity groups in our society retain a sense of liberty and respect in what remains of our liberal heritage. When we identify with our targets, it makes us uncomfortable to explicitly lower their status. Commercial regulations tend to have the same second-order problems and costs as these other regulations. In all of these cases, as "regulation" gets more comprehensive, opaque, and detailed, the costs outweigh the benefits, even though in every case there are certainly good reasons to wish for "regulation" in the dictionary definition sense. In most of our private lives we intuitively understand that these are the (high) costs we bear for living in a civil society - for being human, really. It is only in those realms where we identify a sure "other" that we become confident that control and coercion will create benefits. And, then our policies are more a reflection of who is "other" than they are of any concerted effort toward progress, as with the two contradictory policies that frame this post.

These regulations have more to do with pushing against the status of employers and producers than with the damage of discrimination. These are "you can'ts". You can't use your own judgment to hire the person you want. You can't enter the profession you choose. You cans, where the policy might raise the status of its target, are hard. They usually require functional cooperation from the target of the policy, which leads to frequent failures and problems. You can'ts are easy. It is easy to lower someone's status, and it doesn't require their cooperation.

And, in this case, we can see the damage of the consequences of policies that are imposed based on our subconscious biases. And, these regulations are pretty useless anyway. Most white collar fraud has to be handled in the civil courts, because our criminal system is just too busy with important stuff like keeping you from smoking a mild hallucinogen to bother with things like fraud. And, if you run the gauntlet to get a civil judgment, that probably won't apply to occupational licensing, because it isn't a criminal judgment. So, someone running a fraudulent operation will frequently not have any problem getting a license to do business in your state. But, if they got a DWI, then they are probably out of luck.

This system does little to actually protect you, but it does a great job of keeping people from turning their lives around and aspiring to a middle class ethic once they have a criminal record. It doesn't matter how dense a web of regulations and rules we concoct. None of them will grow a conscience for the state. These examples from coyoteblog are a window into this problem. The state defaults to rules, not to an emergent common sense, so it tends toward being arbitrary and capricious. I think this is obvious to anyone who has ever worked in corporate compliance departments. At some point, you come to terms with the fact that certain forms need to be filed, certain t's need to be crossed and i's need to be dotted, and that it is pointless to busy yourself with anything beyond that. (To some degree, this is a product of bureaucracy in general, not just the state. But, this is where the difference between the right of voice and the right to exit is important.)

The basic motive of liberalism should be overturning the ancient human legacy of "you can'ts" or "you musts", many of them patently and intentionally unfair, with "you cans". This is not a common political intuition. This is why it is so depressing when politics becomes a center of attention. Politics is usually about lowering the status of others. Compare the archetypical political advertisement with commercial advertisements. The comparison isn't even close. In the sectors that are strangling us, housing, education, and health care, there are innumerable "you cans" that should have fairly universal support. You can build a condo building or a house. You can build or expand a hospital. You can be a doctor. You can choose a school for your children. There are a lot of obstacles to all of these "you cans" that reasonable observers should be able to agree on. We need to rediscover a "you can" intuition.

The natural equilibration of a free economy is so difficult for people to understand that even most traders and practitioners seem to fail to wrap their heads around it.

In this comic, we have the banks and the GSEs. The effect of "bailouts" or safety nets for these firms is generally understood, as far as it goes. The effect is explicit in most complaints about those safety nets, but then gets forgotten when applied to social criticism.

I'm not particularly a fan of the private/public GSE model or of the capital requirements and public deposit insurance that form the foundation of public support of banks. This post is not a defense of those regimes. But, if we are going to critique them, let's critique them for the right reasons.

What is the primary effect of the public safety net under banks? The primary effect is to protect lenders to banks. Who are lenders to banks? Depositors are. Public support means that depositors are less sensitive to bank financial instability, because they are protected. Equity holders aren't protected. They are generally wiped out when public support is used to save these institutions. And, what is the effect on those depositors? The effect is that, because their deposits have a public safety net, they have lower systematic risk, and thus, they earn lower yields.

Look in any description of the low risk investments available to savers, and it will describe bank deposits as one form of very low risk saving, then it will describe any number of similar savings options that have higher yields because they don't have insurance.

It's almost like these markets are highly efficient and things like rational expectations overwhelmingly guide markets in ways that we universally take for granted. (But, if you want to be a sophisticated fish, you publish articles casting doubt on the naïve theories about "water".)

Similarly, the complaints about the GSEs always center around the "implicit guarantee" that GSE debt always carried. And, how did we know that there was an implicit guarantee to complain about? Because yields on GSE debt were low! Again, the mathematical relationship between risk and return is explicit in the complaint! The complaint itself is based on a rational expectations, efficiency assumption!

Then, we move to social commentary and we act like none of that happened. Bailouts help the capitalists and cost the taxpayer, don't ya know.

But, every action has an opposite and equal reaction! If you made the complaint, you had to know this! Those safety nets meant that bondholders and depositors earned lower yields. In other words, those safety nets meant that capital incomes were lower - capitalists earned less. Do I need to go all caps on this? Because I will, if I have to!

We can argue about exactly what forms of stabilization are appropriate. And, believe you me, you don't need to twist my arm to convince me that the stabilizing policies of summer 2008 were not exactly optimal. But, this idea that financial safety nets mean capital gets its cake and eats it too is just wrong. The only way to have it both ways is to regulate away potential competition. Markets with reasonably free entry can't help but pay it back.

And, in the meantime, there seems to be near unanimity about maintaining instability and keeping out competition in the housing market. "Oh, no! It's time to tighten again! There are homeowners who still think real estate is a safe investment. When will they learn?" And, gee, guess what investment has yields well above the alternatives and far above the pre-crisis norms? Rent income is through the roof. No comics about that though, because for those yields to go down, prices and supply would have to go up, and a sophisticated fish knows there can never be not enough, only too much.

Sunday, June 18, 2017

This is a great article from Josh Brown. It's an article I'd like to think I would normally write. He basically says to calm down about the flattening yield curve. Economies can have years of healthy growth with flat yield curves, even if inverted yield curves are a sign of a coming correction. This is an excellent point, and normally I'm more than happy to fight the perma-bears and the bubble-mongers. But, at the risk of being shown a fool, "This time it's different." (Maybe it's safe to use that phrase in defense of being a bear.)

First, the most significant reason long term rates are low is because we have constructed barriers to long term residential investment. This is why GDP growth has been anemic, why the labor recovery was somewhat weak, and why there have been headwinds for consumption and balance sheet recovery. Especially in working class neighborhoods, home prices are still 20% or 30% too low because we have destroyed owner-occupier demand in those neighborhoods, which creates real losses and introduces agency costs to tenancy while also harming working class balance sheets.

So, the reason for the flat curve is a lack of investment, and its already putting both real and nominal economic growth on crutches.

Second, real bank lending is already stagnant. It has been for about 3 quarters. This is usually a lagging effect and it points to my third point.

Third, the yield level may have a significant effect on the slope of the yield curve. The zero lower bound creates non-normal distributions for expected future interest rates, which prevents the long end of the curve from flattening as much as it normally would. In other words, there is option value in long term interest rates. I know I am certainly much more willing to take speculative short positions on bonds when rates are very low. There is a lot of skew here.

Notice how inverted the yield curve became in the late 1970s, when rates were high. 1990 and 2000 were pretty shallow recessions and in both the inversion was also pretty shallow. But, the 2008 recession was more akin to the 1980-82 recessions, yet the yield curve inversion was much more shallow. In the late 1970s, rates were around 10% to 15%. In 2007, they were about 5%. Today they are 1%. I think it is pretty clear that a contraction will happen without a true inversion here. The question is how much slope will we have when the natural short term rate starts to fall without a response from the Fed. We could be there already. If we get a couple of bullish head fakes, which is certainly possible in the inflation indicators over the next couple of months, the Fed might even push another rate hike.

I think the Fed's general stance, the broad demands for destabilizing monetary austerity, and these yield curve distortions make a contraction within the year probable.

Wednesday, June 14, 2017

CPI less food, energy, and shelter, is down to 0.6%, TTM. It looks like shelter inflation might have peaked too.

The three month drop in the non-shelter core measure is the worst drop since the BLS began tracking it in the 1960s. Down about 0.5% since February.

And the Fed raised rates.

This is different than the last recession, though. Things aren't lined up the same. We're still raising rates, so rate-sensitive things may still be similar to a 2005 or early 2006 time frame. That has me a little confused. I'd like to take some positions that would benefit from falling rates, and the yield curve is already moving down. But, if the Fed will push short term rates up one or more times, it muddies the water a bit, because the entire curve tends to react to those moves, if only temporarily.

Employment still seems relatively strong. Flows are holding up pretty well. That also looks like 2005 or 2006.

Inflation looks like the middle of 2007.

General credit is still growing, it seems. But, bank credit is flat as a pancake, which is usually a coincident indicator. Even without these inflation indicators, I would be a little nervous to see rates being pushed up with bank lending so weak.

I think the Fed is committed to recessionary policy at this point. If (when) they push rates up to much, I don't think they will be quick in reversing their decision, either. It's a matter of when the various moving parts affect different markets, though. When do interest rates decline? When does the labor market turn sour?

I don't think we will see much downward movement in home prices, housing starts, or equity prices unless things get really bad. And, I still am having a hard time coming up with a detailed forecast for some of the other markets.

If signals turn south over the next couple of months, maybe the Fed will hold off. But, the Fed sees this softness as temporary, and if some inflation measures have been temporarily down and bounce back, the Fed might see that as cover to raise again, maybe even in September. I would expect that to lead to a fairly immediate flattening of the yield curve, after which it would be a matter of time before the Fed relents and lowers rates. It used to be common for rates to peak and fairly quickly be lowered again. But, lately, the Fed seems to like to sit at the peak rate level for a while before they are willing to lower rates in reaction to economic softness.

I think that's because Closed Access creates a sense among the public that nominal stability only benefits existing asset owners, so there is a strange demand for instability. I don't see that changing in this cycle.

Friday, June 9, 2017

This will probably be a long post. And I may be totally out to left field here. This is sort of a stream of consciousness post. I apologize in advance if it is hard to follow. I've been editing to try to be readable for the book. I feel like just puking out some ideas on the blog for a change.

First, let me preface this by saying, I am not talking about whether the Fed was hitting their targets or meeting their mandates, as measured, our whether NGDP growth was above or below some threshold. I am trying to get at something more subtle that maybe is only clear in hindsight. This isn't a post about second guessing what was done as much as it is a post about what some of the subtle effects of Closed Access could be, and how they might undermine our basic methods for recognizing economic cycles.

Some observers believe that the Great Recession was more a product of tight monetary policy decisions from late 2007 and 2008 than it was a product of the housing bust. I agree. But, I tend to push that tight money problem back to early 2007 or even 2006, and I would suggest that the mortgage bust, as we have come to know it, was really a product of the Great Recession.

First, clearly there was a panic that began around August 2007 which destroyed the cash-like character of trillions of dollars worth of securities. Regardless of one's opinion about Fed policy up to that point, this was a massive dislocation in the market for near-cash securities (Gary Gorton has written about this) which the Fed never countered, at least until the QEs kicked into gear in 2009 and after. This was followed by policies in late 2008 which were explicitly contractionary, both during and after the crisis events at Lehman Brothers, the GSEs, and other institutions.

Now, considering this, what do we consider to be the defining characteristic of the housing bust? Defaults? Defaults overwhelmingly happened after 2007 - even after 2008. If we define the housing bust by defaults, then clearly tight monetary policy caused the housing bust. There really is no question about this. Many anecdotes about defaults filled the papers of 2006 and 2007, but in terms of scale, defaults were overwhelmingly caused by the economic dislocations in late 2008 and 2009. (Like so many issues regarding the housing boom and bust, the scale is alarming. This is mountains and mole hills. Defaults in 2006 and 2007, which were blamed on bad underwriting and supposedly triggered the collapse are a mole hill next to the mountain of defaults that happened when unemployment shot up and NGDP growth collapsed.) Defaults accelerated after the August 2007 event and accelerated again after the September 2008 event. More than 90% of the excess foreclosures happened after August 2007, more than 80% after September 2008.

(Even if you believe that prices had to collapse and that monetary and credit policies before September 2008 were appropriate, then, still, an economy full of homeowners with negative equity creates an even more important need for stability of employment and purchasing power. So, really, even when it comes to the 2007 collapse in private securitizations, monetary and credit policy is endogenous, because those AAA securities broke below face value because of expectations of future defaults. And those future defaults were bad enough to justify that collapse in valuations only because we explicitly chose public policies that allowed them to happen. There is little controversy about whether we could have stabilized the economy and the mortgage market more. The controversy is whether we should have. The idea that the private securitization collapse caused the Great Recession is circular. If it did, it is because we chose to allow it.)

How about prices. Is the housing bust defined by collapsing home prices? At the national level, the collapse clearly kicks into gear after August 2007. Prices had been flat from the end of 2005 to August 2007, moving within a 2% range for that entire period. The national price collapse happened after the August 2007 panic. The private securitization market had completely collapsed, banks were defensive, and pressure was being applied to the GSEs to pull back. The only mortgage conduit capable of filling the gap was the FHA/VA conduit. Funding for homebuyers collapsed, and prices collapsed with it.

GDP growth began its steady decline around then (NGDP growth began to decline in mid-2006, but the decline accelerated in 2007.), the recession officially began in December 2007, unemployment started to shift up, etc. Except for some commodity inflation, signs are pretty clear that monetary policy was too tight at this point. So, if we either identify the housing bust by defaults or by prices, in either case, the housing bust happened after monetary policy became contractionary. As with defaults, the price collapse accelerated after August 2007 and again after September 2008.

How about housing starts? Housing starts and residential investment began to collapse at the beginning of 2006. This is a little more subtle. Before I get into this, though, I would point out that I think defaults and declining prices would be the most common characteristics associated with the housing bust, and that generally those things happened later, relative to the general economic decline, than is generally appreciated. This is mostly because the small rise in delinquencies and defaults in 2007 was reported on with much more intensity than the many, many defaults that happened later. The housing bust, as a proposed cause of the recession, is rarely described in terms of housing starts. So, nothing that is commonly associated with the housing bust was really happening before August 2007.

As I have argued before, I think this early phase of the bust, where contraction was mainly manifest in declining investment, is actually the first sign of economic contraction, it was a development that was generally encouraged because of the mistaken idea that there were too many houses. Fed members generally saw this as a positive development. Mortgage growth continued through 2007. I think this is generally because the rate of new first time homebuyers is more stable than other segments of the market, and these tend to be more leveraged buyers, so there is a natural stickiness to mortgage growth. But, mortgage growth rates kinked down at the beginning of 2006, just like investment, housing starts, and home equity levels did. It just took a little longer to adjust down.

This is the period where equity as a percentage of real estate values really started to collapse. Prices were still relatively stable, but mortgages outstanding continued to rise, thus the rise in aggregate leverage. Homeownership was falling by then. I have argued that much of this shift was due to an exodus of capital out of home equity, much of it in the form of owners selling and not repurchasing new homes. By 2006, first time homebuyers were in decline and exiting owners were increasing at the same time. In addition to that shift, there was a shift of households out of the Closed Access cities.

Data from American Community Survey

During the boom, these were households selling out of the high priced cities and repurchasing in lower priced cities. During the boom, some of those homes were purchased by households who were moving into the Closed Access cities, but most of them were purchased from existing Closed Access households who had been renters. In both cases, this was a shift in ownership from lightly encumbered households (because they generally had significant capital gains) to more leveraged households.

This is where the interpretation is a bit subtle. Generally, the housing bubble idea is based on the idea that the unsustainable supply of credit led to capital gains which would inevitably be lost, and that households were spending those capital gains on consumption. But, what if prices reflected reasonable valuations of future rents, and credit supply was simply facilitating the purchase of what were really economic rents from exclusionary local political policies regarding housing? Then, that consumption wasn't unsustainable. It certainly wasn't unsustainable for those Closed Access outmigrants who realized their capital gains. And, the new homeowners that purchased those homes weren't using those mortgages to fund non-housing consumption. They were using the mortgages to fund the purchase of those expensive homes, and they were, in fact, probably crimping their other non-housing consumption as a result.

We can really think of other homeowners the same way. Even if a household retained their home and got access to their gains by taking out home equity loans instead of selling their property, they were still accessing economic rents, just like the households that sold or moved. The value of the homes were just as permanent. They just chose to continue to hold those homes as unrealized gains instead of selling them and realizing those gains.

Mian and Sufi estimate that during the boom these home equity extractions amounted to at least 2.8% of GDP. We can see this simply by comparing residential investment with mortgage growth. Generally mortgage growth runs slightly below residential investment, but during the boom, mortgages outstanding were growing by about 2% more annually than residential investment was (as a % of GDP).

The Fed, trying to maintain low inflation, was countering this by reducing currency growth. I'm not saying they were targeting currency growth. I'm just saying, if mortgage growth was leading to increased bank deposits that were related to rising consumption, a central bank targeting inflation will naturally limit currency growth. We can see that PCE core inflation was generally at target during this time, even though currency growth was very low.

Note, by the end of 2006, much of the excess mortgage growth was gone. Since then, households have had to fund residential investment from other sources. But, currency growth continued to fall until the summer of 2008.

Now, a reasonable response to this is that, while the Fed might have been a little tardy in reacting to the collapse in mortgage growth in 2007 and 2008, it was perfectly reasonable for them to counter the inflationary pressures of mortgage growth before then. In terms of viewing monetary policy through the Fed's stated targets and mandate, this is certainly true. Even in terms of NGDP growth, in late 2006 and early 2007, nominal GDP growth was sort of on the cusp of growth rates that would normally be considered recessionary, and it was subsiding, but it wasn't at a rate that is undeniably recessionary.

Unemployment was also stable, although I would argue that employment growth was actually beginning to weaken substantially, and that the first phase of contraction led to a reversal of the Closed Access out-migration surge, which was a buffer against rising unemployment. This caused the early signs of cyclical dislocation to be hidden, so that by the time unemployment became a signal of contraction, there had been many months of internal stresses within the economy. Even having said this, though, the rise in unemployment in the US predates the rise in other countries. Something unusual was happening here by early 2007.

Setting Fed mandates and targets aside, though, what does this mean simply with regard to stability itself. What if much of that new housing wealth was the capture of economic rents? These were largely future potential economic rents, which will eventually be earned through excessively high rental rates on those properties. Those future rents are capitalized in today's home prices. This added consumption wasn't being financed by using unsustainable capital gains to borrow from financiers. It was financed by those future economic rents.

﻿﻿This was basically consumption smoothing by rentiers. The rentiers were consuming today out of their capitalized future economic rents. And, on net, we would expect non-rentiers to lower consumption as they suffer from the losing side of the surge in rentier incomes. Rentiers explain the increase in borrowing. Non-rentiers explain the increase in low risk investments, such as AAA securities.

Current consumption was being claimed by non-producers. That isn't controversial. My tweak to the story is just that this consumption wasn't unsustainable. So, this means that there would be inflationary pressures. This means that the rentiers were claiming current consumption from the non-rentiers - they were outbidding them.

What if those gains were sustainable? Then we have an economy composed of rentiers and non-rentiers. According to Zillow, from 1998 to 2006, total value of Closed Access residential real estate increased from $2.9 trillion to $7.4 trillion - most of that after 2002. Even in real terms, this was an increase of about $4 trillion. Mian & Sufi estimate extracted home equity, nationally, from 2002 to 2006 at $1.45 trillion. If that is a transfer from non-rentiers to rentiers, that is a major economic dislocation.

Mian & Sufi's 2.8% represents all borrowing through this channel, so consumption would only be a portion of that. On the other hand, this measure does not include capital gains captured by households either selling homes into the boom or selling high priced Closed Access homes to move to lower priced cities. Adding all of these sources of current consumption together, it seems that this transfer of rents accounted for much of the growth in personal consumption during the boom.

Real GDP growth per capita was significantly higher in the Closed Access cities during the boom than it was elsewhere, by the way.

Taking all of this together - the low level of currency growth, the significant rise of credit fueled spending, and the moderate levels of total spending and of inflation - suggests that there was a shift in consumption toward households who were harvesting capital gains from housing. All else equal, without that shift, inflation would have been negligible and nominal GDP growth would have been very low.

Again, I don't think I really need to assert anything here. This is not controversial. The idea that debt was fueling consumption is universally accepted. But, the difference between irrational, unsustainable capital gains and harvesting of permanent economic rents is pivotal here. What would happen if the source of consumption was from the harvesting of permanent economic rents? Imports would rise. Savings would increase.* Debt would rise. Everything that happened would happen. And, if the central bank didn't counter all of this, then inflation would rise, too. But, the central bank did counter it.

We are an open economy, so when the central bank countered the inflationary effects of this consumption smoothing, at first, it didn't create a problem. We purchased imports - which, again, were seen as unsustainable overconsumption from debt, but really were consumption smoothing from the owners of our increasingly exclusive asset base. Inflation is basically a product of monetary policy, and as long as it isn't disruptively high or low, it shouldn't matter that much. Eventually it mattered because policy became disruptively tight - first leading to extremely sour expectations in real estate markets, then a breakdown in mortgage markets, then finally a sharp downturn in consumer inflation and NGDP growth.

But thinking about inflation in this way, the question arises: how exactly was monetary policy to blame for the housing bubble? And, how was tightening it supposed to be the cure? Even in the conventional telling, that this was all reckless and unsustainable debt fueled spending, how was lowering the inflation rate supposed to help? I mean, if housing debt was allowing households to claim an extra 2% of current consumption, why would that be any different if inflation was 5% or 0%? Those households were using access to nominal spending power, but they were claiming real output. Why would a change in inflation change that?

The only way monetary policy could change that is by lowering expectations so much that it induced a crisis of confidence in the housing market by causing home price expectations to collapse - to fall into negative territory. And, this is clearly what had happened, in a pretty extreme way, by no later than mid 2007. The Fed's response to these collapsing expectations was to say "the housing correction is ongoing", and to continue to use that term - "correction" - through the end of the year, even after the collapse of private securitizations.

To this day, this is explicitly and widely supported. The problem, the story goes, with the economy in 2006 was that all those starry-eyed speculators thought that home prices never go down, and that if there was any mistake about how we handled it, it was that we didn't set up markets for those prices to fall earlier. I am making a damning accusation about the policies that were widely demanded and enacted in this country at that time. This is awkward, because it should require some contentious claim about what was being demanded. It's awkward, because the claim itself is not contentious at all. The explicit demands to create negative expectations in the housing market were broad and loud then, and they are still broad and loud.

The reason my criticism is so damning is because the premise was wrong. The reason my criticism is so damning is a boring little scatterplot which shows that the capital gains funding that consumption were from permanent economic rents. While the country was fretting about how home prices were becoming unmoored from rational value, rent was becoming a more and more important factor. It still is.

Notice in the graph how most metro areas basically fall on a line that intersects the origin. In other words, prices and rents were fairly proportional. (In 2007, the Contagion cities were causing a bit of a bulge at the top end of the mass of less constrained MSAs, pulling it slightly above the proportional line.) But, in the Closed Access cities, and generally only the Closed Access cities, the relationship is not proportional because the price also reflects future rent expectations - a cash flow growth premium. By 2015, even with a basic, linear, unweighted regression between median rent and home prices among MSAs, r^2 is above .85.

Notice one thing that nobody ever expected. Nobody expected the rents in those high priced metropolitan areas to decline. We aren't about to see a correction there, even though that is where the correction is needed. This would require a resurgence in housing - at least in terms of building and lending.

This realization should create a wholesale shift in how we view monetary policy at the time. Monetary policy was countering this housing-fueled consumption. But, this wasn't coming from a widespread dissemination of debt to marginal households. This was coming from a minority of households who had become quite wealthy by obstructing access to opportunity through repressive housing policies.

This seems like the classic problem of a non-optimal monetary regime. There were two distinct types of Americans - those who were consuming gains from economic rents and those who were not. The first set didn't need monetary accommodation. The second set did.

But, in the end, this problem is dwarfed, I think, by two more important factors.

The consumption fueled by housing gains had nothing to do with monetary policy, except that before 2007 we were within a range that allowed the economy to function. And a functioning economy that contained these pockets of Closed Access was bound to have high home prices. When we left that range in 2007 and 2008, that source of consumption was undercut. But, of course, this catastrophe was applauded, not derided. "If only we had done it sooner."

The effect of the expectations channel overwhelmed any negative effects of the more conventional damage tight monetary policy might have caused for the have-nots. As I review the data, even the decline in migration out of the Closed Access cities that began to happen in 2006 was mostly due to the decline in migration among homeowners. The disruptions were targeted to recent homebuyers in Closed Access and Contagion markets. When those disruptions took hold, the Fed didn't discontinue its tight policy, and since policymakers thought working class borrowers were the source of that extra consumption (They weren't.), they severely clamped down on lending to those markets in 2008 and after. And, it was late - in 2009 and 2010 - that those households were hit. But, even there, the hit was largely through housing, as working class neighborhoods really took a beating as a result of those late policy choices.

But, even though this was related to expectations specific to housing, it is still intertwined with monetary policy and the problem of rentier and non-rentier needs. Some neighborhoods in places like Dallas started to see slow price declines in 2006 and 2007, accelerating in 2008. Dallas was non-rentier territory. An extra 5% of inflation over that period might have done wonders for sentiment in places like Dallas where home prices were never particularly high.

It only got worse after early 2008. Regarding working class homeowners, one might properly conclude that the housing collapse did cause the recession. But, in that case, it was tight creditpolicies from the GSEs and Dodd-Frank, in 2008, 2009, and 2010, that caused dislocations in those communities. Low tier home prices didn't collapse across the country in 2009 and 2010 because of bad underwriting or excess prices in 2005. So, for those communities and neighborhoods, it was the credit-policy induced housing bust of 2009 and 2010 that exacerbated recessionary conditions in 2009 and after.

Because the exodus of homeowners that had been growing throughout the boom and accelerated in 2006 and 2007, home equity levels collapsed much more strongly than valuations, both the growth of mortgage financing and the harvesting of equity continued to boost consumption after expectations in the housing market had soured. In addition, sanguine attitudes about the collapse in housing starts meant that there was no natural buffer for declining investment by the time of the first panic in August 2007 and by the time the recession officially began. Housing starts were already at levels normally associated with the depths of a recession. Prices began to collapse, in part, because the shift in quantity supplied that could come from changing rates of new building had already been mostly exhausted. This was met with indifference because of the mistaken notion that we had too many homes. Ben Bernanke still thought there were too many homes in 2011, and he was far from alone.

For many of these reasons, the collapse was felt first in changing expectations about home prices. Obviously, negative expectations about values create a natural dislocation in ability to use an asset as collateral.

Here is where you might scold me and explain that it isn't the Fed's job to keep home prices from declining. I certainly agree, with regard to idiosyncratic price movements. But, these were nationwide. As a start, we should have a strong presumption that broad changes in sentiment and price have a systematic or monetary source. And, obviously my contention that prices are mostly capitalized economic rents from future political exclusion is important here. But, even setting all that aside, let me suggest that all of our measures of monetary policy effectiveness - inflation, output, NGDP growth, etc. - are not the end goal of monetary policy. They are proxies. They are proxies in the service of stability in the business cycle. In the end, regardless of what we think those proxies were signaling to us, they are only proxies. If every tactical target the Fed has is on the nose, and an imminent collapse in housing sentiment is going to lead to a generation defining recession, then proxies be damned. We shouldn't let tactics take the place of the mission.

I don't blame the Fed for looking at those proxies. It's not their "fault" in that sense. But, just because the proxies failed doesn't mean that the any of these series of developments were not, in some sense, monetary issues.

But, even saying that, the horrible truth is that we imposed three (really four) stages of collapse on ourselves. (1) the housing exodus in 2006 and 2007 that coincided with collapsing investment and the retrenchment of migration that had been flowing away from the high cost cities, (2) the August 2007 securitization panic, (3) the wider panic of late 2008, and (4) the federal denial of credit and the late crash of working class housing markets from 2008 to 2011 (and really to this day). The initial collapse in sentiment might not have even been catastrophic if we had stopped after #2. Maybe a generous lending policy from the GSEs in 2008 would have been enough to stabilize the economy even with a very tight monetary policy. Surely the lack of mortgage access had something to do with the sharp drop in low tier prices, and the sharp drop in low tier prices was the root of rising defaults, collapsing securities valuations, etc.

The counterfactual that would be interesting to know would be whether systematic support of generous conventional lending in 2007 and 2008 and after would have been enough to counter any cyclical effects of the repricing in the Closed Access and Contagion cities that might have come from the collapse in private securitizations. That repricing had happened by the tragic late 2008 episode. I don't think that most of that repricing was necessary, but in any case the credit repression that happened after that and is still happening - after monetary policy finally became more accommodative (over much public consternation) - was egregious and unnecessary by any measure.

* Much of the savings was from foreign sources. And much of it was unmeasured because capital gains on those homes are not counted as savings, even though they really are savings if they are permanent, and they certainly are savings for the many households that sold and realized those gains.

Saving rates look low throughout the Closed Access era because the capital gains are received as savings by the rentiers, but they are not recorded as savings. Whether these are properly considered savings or not depends on if the gains are sustainable. They are if they are capitalized rents. They aren't if this was just an irrational credit-induced bubble. This is the trouble with this topic. Our interpretation of events affects the causal inputs.﻿﻿

Thursday, June 8, 2017

OK. This will probably brand me a hopeless radical - a naif - someone with such an absurd fundamentalist faith in markets that it's just not worth talking to me. But, here goes. I propose we get rid of the FDIC. Just get rid of it. Let savers fend for themselves.

What could happen? Well, there was a time, I believe, when bank CFO's would actually be accountable for losses and they would take out private insurance policies. Or maybe, a private deposit insurance market would develop for banks. Or clearinghouses that would backstop failing banks. Or, maybe banks would publish their balance sheets and depositors would consider the riskiness of their portfolios before depositing their cash. Maybe banks will actually end up being less leveraged, and the system will be more safe. It seems like all of these developments might be better than the system we have. In a way, I think many of the major issues in banking today come down to public deposit insurance that misprices its policies so that banks can get too leveraged or too big, etc. It seems like a lot of problems could be solved simply by pricing deposit insurance more efficiently.

I don't think any of that needs to happen. In fact, I suspect that in an unregulated market, there wouldn't be any deposit insurance, because there would be no demand for it. Depositors would only give the slightest attention to the books of the banks where they made their deposits, mostly just depending on brand reputation as a signal. And, I think this would lead to a market that you might call a sort of crazy Wild West. I think you'd end up with banks that were highly leveraged - not 10 to 1 or even 20 to 1 or 30 to 1 - but, basically with no equity at all. Depositors would be drawn to deposit in those banks. Some might say duped. But, I say we should try it. Even if that happens, I think we'll be alright. I think things will work out just fine. I've been thinking about this, and I even have come up with a name for this proposal. The name for these new banks would be "money market funds".

Wait. Maybe you object. We already have a thing called money market funds, and they are exactly the opposite of this. They aren't leveraged at all. They are generally very safe. Don't they basically meet my description, though?

Oh, the leverage thing? Well, a bank is 90% leveraged because they have 10% in equity capital and 90% in deposits (which are liabilities to a bank). A money market fund has 100% deposits. The only reason we call it unleveraged is because money market funds don't have FDIC insurance. FDIC is a magic formula that turns equity into liabilities.

Safety? How many failed banks required FDIC actions after 2007? Hundreds? How many money market funds? As far as I know, just one, at the height of the crisis when CPI prices collapsed by 2% in a single quarter - the Reserve Primary Fund. It came up short in the amount of one or two billion dollars. I believe savers received 99.1 cents on the dollar.

There is about $2.5 trillion parked in money market funds. And, they invest in reasonable short term investments. How is this not proof of concept? What am I missing? How is FDIC insurance and the complex web of regulation surrounding it in order to maintain safe deposits at commercial banks anything but a kludge intended to maintain an anachronistic set of financial institutions which keep creating systemic risks by mismatching assets and liabilities?

It seems like there is a place in the economy for financial intermediaries that take on credit risk with local entrepreneurs, commercial real estate investors, etc. It seems like there is the potential for a bank with operational capital to capture a decent profit in that business. What's the point of having that institution also take in deposits just to buy MBSs, sell and retain long duration mortgages, buy treasuries, etc.? In a world with money market funds, why does this still exist? Why shouldn't we have banks that take credit risks, with liabilities and capital that match the maturities and risks of that business, and banks that don't take credit risks, and meet the demands of depositors with short maturities? Instead, it seems like we are mixing these mismatched assets and liabilities and we are cobbling together a bunch of capital requirements which are determined by the bank's assets, but which really are aimed at meeting the demands of liabilities that really have no business being involved in the funding of those assets.

Is there something I am missing here?

It's not like we would be in some sort of unknown universe without FDIC insurance and capital requirements. And the downside seems to be that once in a lifetime, if we learn nothing about creating a more stable macro economy, a few savers lose a penny.

Tuesday, June 6, 2017

Reader Chuck Erickson pointed me to this article, which I had missed. The article engages in the sort of framing that baffles me regarding the housing market. I think, at the heart of this problem, is a public confusion about the difference between owning a home and utilizing the services of a home (consuming housing services, or making housing expenditures).

I think this confusion comes, in part, from the fact that homeowners do not make regular rental payments to themselves, but all homeowners have expenses for maintenance and upkeep, and many owners make monthly mortgage payments. The only difference between owner-occupiers and renters is the fact that there is no cash rent payment. Both owner-occupiers and landlords have upkeep and financing expenses. But, these represent a fairly complex set of expenses, including depreciation, which owner-occupiers mostly replace with very imperfect heuristics about cash expenses.

This is exacerbated by the fact that ownership carries with it real value. First, there are the various tax benefits. But, secondly, there is real value in having ownership control over such a personal asset. So, the act of taking ownership represents a form of consumption that is separate from renting the property. The owner-occupier gets value from control, and in this way, buying a home really does represent a different type of consumption from renting - it gets placed in a different mental category. For many households - those with a settled lifestyle and the means to become owners - renting would be a very poor substitute for owning. So, financial advisors and families generally tend to balk at the notion that homeownership is a financial decision, similar to investing in something like bonds.

At the personal level, this confusion may work fine. The fact that financial advisors seem to pretty universally treat homeownership as something different than other financial allocations speaks volumes here. There must not be that much value for most households to be careful about these distinctions, so we tend not to worry about them that much.

But, the problem is, these distinctions are important when it comes to analyzing macro-level markets. And, since few people have been bothered to think about these distinctions at a personal level, there is no channel through which these distinctions materialize into macro-level discussions.

So, there is an obvious central factor in housing markets that seems to be easily forgotten: homeowners are housing suppliers.

The article quotes the National Association of Realtors (NAR): ".... contract activity is fading this spring because significantly weak supply levels are spurring deteriorating affordability conditions."

This is technically true. But, if we think about the difference between owning and using a home, it's a little more complicated. The affordability problem right now is wholly and completely a rental problem. It's a problem from lack of supply that is raising the cost of utilizing housing services. There is no affordability problem for homeownership. Practically any house you view at Zillow will have a much higher rental value than a mortgage expense - especially at the low end of the market where home buyers would have marginal credit. There is absolutely no affordability obstacle to homeownership right now.*

You can spend 40% of your income on rent and Elizabeth Warren isn't going to demand that heads roll, but if you and many of those other renters spend 40% of your incomes on mortgages and then a cyclical downturn leads to defaults on those mortgages, then just turn on C-SPAN and watch out. There is a natural demand for housing. We aren't going to force families to live under a bridge to meet some sort of affordability standard. But we are happy to force them to rent. We are quite proud of it. Macroprudence, we call it. But, there can't be a natural supply of housing if we legally obstruct it - either in real terms in the Closed Access urban planning departments that block actual building, or in nominal terms in the national mortgage market that blocks funding.

There is a source of supply from landlords, which has been quite active. But, since shifting from owning to renting means that a household loses that control value, and since we rain largesse down on owners, we have two markets - an owner-occupier market, where the demand curve shifts right, and the renter market, where the demand curve shifts left. And, we have added an additional rightward shift in owner-occupier demand because the obstructed mortgage market means that interest rates are low and true returns to homeownership are kept high. Owner-occupiers might have higher imputed rents, but they never pay themselves that rent, and they get a boost in the yield of their investment because regulators are keeping the riff-raff out of the ownership market. In this way, they are kind of like the banana plantation owner without the liquid market. They have high returns, but those returns can only come from ownership. They can't be realized as capital gains. Those who bought when the market was liquid, just before the bust, thus, have capital losses. (And, of course, the investor buyers get blamed for driving up prices, even though the thing keeping buyers out is clearly the ability to get any mortgage, not the cost of a mortgage that has been offered.)

In addition to bemoaning the lack of supply and "affordability" problems, the article blames a shortfall of buildable land in the high priced cities. You know, those cities where the planning department is just begging developers to come in a create supply, and the builders just shrug and say, "Sorry, there's just no place where we can build." Those cities. (It seems like it must be true, though doesn't it? It seems so plausible.)

The article ends:

Whatever happens, it is apparent that housing dynamics (price and quantity) is not supporting a growing population living in the traditional array of housing arrangements. More unconventional housing arrangements (compared to history) appear to be operational, either by economic choice (housing affordability) or some other combination of reasons.

The answer to this problems is clear, and it has nothing to do with affordability, from an ownership standpoint. The answer to the problem is that liquidity is a public good, and since we determined to learn all the wrong lessons from the housing boom and bust, we have insisted on imposing a liquidity crisis on ourselves. This happened in acute form in 2007 and 2008 as credit market dynamics and the money supply were shifted to the point of panic. And, it has happened since then in mortgage markets in more chronic form as regulatory pressures and federal control of the GSEs has pushed average approved FICO scores up by 40 to 50 points above any previous standard.**

Now, real estate has never been a particularly liquid market, so that the main reason a household would choose to buy instead of renting is how long they intend to stay in the home. If it is long enough to justify the transaction costs, then generally you should own. To the extent that there was ever an issue with affordability, it had to do with the fact that leveraged ownership required high cash outlays because mortgages generally require the inflation premium to be paid in cash while homeownership earns its inflation premium as unrealized capital gains over time. There is a natural savings to ownership because of the control premium and because much of the expense is in the form of depreciation, which allows for some deferred costs. Because of the confusions mentioned above, this has gotten filtered through public perception as if the affordability problem somehow comes from owning being inherently more expensive than the alternative. This is just not the case in a low inflation environment, and it certainly isn't the case when implicit returns to homeownership are excessively high because of policies that limit access and liquidity in housing markets, like what we have now.

In effect, what we have done is analogous to closing down the stock exchanges as a matter of public policy. Equity values would obviously drop like a rock in that scenario. That is because liquidity is a public good. Equities are worth more now because liquidity has real value. We have private and public financial institutions that provide that liquidity, so equity owners demand lower returns on their investments, which means that prices for equities are higher.

Now, imagine if we closed down the stock exchanges and took away that liquidity, and if we were oblivious to the effects of what we had done. Many people who might own a few shares of Amazon today would be locked out of equity ownership in that context. We might complain that equity ownership was unaffordable for many people. It would be. Even though the market value of Amazon would be lower.

While equity owners would be earning higher profits for their investments, there would be an affordability problem for consumers - those using the services provided by those firms. Those higher profits would come from higher prices for their goods and services. There would be an "affordability" problem. Consumers would be worse off.

We would all simply be worse off in that world. Except that those who had the wherewithal to make private equity investments in equities would earn much higher returns on their investments while everyone else would be stuck in more accessible securities with lower returns. (Huh, fixed income returns since the end of the housing boom have been mysteriously low. What a coincidence.) As ubiquitous as the complaints about bubbles and hot markets are, I'm afraid we are at a point in history where this would be considered an improvement. In fact, I think this is basically our problem.

In this analogy, homeowners are like the equity owners, and tenants (both owner-occupiers and renters) are like the customers. Our confusion about homeownership does such a number on our understanding of the housing market, that the way we talk about housing markets is the equivalent of seeing high prices for corporate goods and services and complaining that there is an affordability problem for shareholders.

The solution to that problem in equities would be to open the stock markets back up. This would democratize ownership, bring in competition, bring prices on goods and services down, bring profits down, and raise equity prices. This is what needs to happen in housing.

You want home prices to decline, lets get rid of the tax benefits that amount to a 25% premium on aggregate home values. Maintaining that regime while we fret about bubbles, about the measly quarter point or so interest rate discount created by the GSEs, and about affordability, is dumb. The causes of the problem here are right in front of our eyes, and they are not subtle. We are doing this to ourselves. And we have been casting blame and fear in all the wrong directions.

PS. This may be a good post for feedback. Am I starting to write in a sort of idiosyncratic language that is impossible to follow, or are the concepts above somewhat accessible?

* This isn't true in Closed Access cities. In those cities, mortgage expenses tend to be higher than rental expenses, especially when you factor in cost of ownership. That is because Closed Access houses don't just represent the ownership of existing shelter. Rents there have a growth rate. These are like buying an early stage growth stock. Much of the value comes from owning future limited access to a prime location in an increasingly segregated country. They are long positions in systematic political exclusion. They are the result of marrying the value of land access as in a banana republic with the liquid markets of a developed economy. A sort of meritocratic elitism available for sale to the highest bidder. Heirs to banana plantations are local elites, but in return, they must be in the banana business because their ownership rights are personal, not universal (see North, Wallis & Weingast). Heirs to Closed Access real estate can sell their little housing services plantations to aspirational young programmers and designers, venture capitalists and investment bankers, and invest their gains in other assets or retire to the mountains somewhere.

** Here's where you tug at your pipe and explain that back in your day, home buyers saved for years first, always put 20% down, walked uphill both ways in the snow, and there were never any financial crises. And, you knew who you were then. Girls were girls and men were men. Mister, we could use a man like Herbert Hoover again. Didn't need no welfare state. Everybody pulled his weight. Gee, our old LaSalle ran great. Those were the days... There was probably buildable land in the big cities then too.

Thursday, June 1, 2017

There is one irrefutable fact that we can all agree is true: Home prices were very high in parts of the US in the 2000s, and continue to be high in some cities, as well as in parts of several other developed economies.

We can ask the question, is this because of supply side factors (limited access to valuable real estate) or demand side factors (tax benefits to homeowners, loose monetary policy, frothy mortgage markets, speculative frenzy, etc.) This is what is so odd about public consensus on this topic. We have never really asked this question. Yet, the supply side problem is embedded in all of the demand side explanations about housing bubbles. I don't think there is any disagreement that for those demand side factors to cause a bubble, there has to be inelastic supply. So, the supply side explanation for housing bubbles is imbedded in the demand side explanations, and then everyone goes galloping off with demand side explanations, as if those are the important factors. The premise has been predetermined and the conclusion arises entirely from the premise. This is begging the question.

Isn't it strange that there isn't any particular homogeneity in the demand side factors among the various places with housing price concerns? Fixed versus adjustable rates, long term amortization versus short term with balloon payments, different central banks, public guarantee programs versus private markets, recourse versus non-recourse loans, etc. So, in the US, Canada, Australia, UK, France, etc., a consensus builds around whatever the local set of demand side factors is, and blames those for the "bubble", even though they are different in every location. Of course, those dastardly foreign buyers are always a demand-side factor.

The bias here is extreme. The Financial Crisis Inquiry Report by the federal commission on the causes of the financial crisis (the FCIC) is a great example of this. It's a great summary of the boom and bust. There is a lot of information in there, presented well. Yet, it simply treats the issue as a problem of excessive lending and speculation, a priori. As far as I can tell, limits to urban housing supply are mentioned once, briefly, in one of the dissents at the back of the report.

Now, even if one insists on focusing on the demand side and on the brief spike in prices in the Contagion cities, where the argument for an unsustainable bubble is strongest, at the center of that story are millions of Closed Access housing refugees flooding out of the Closed Access cities and into the Contagion cities. A lack of urban housing is the core causal factor even in the Contagion bubble. The report makes no mention of this.

What we get, instead, is just a litany of anecdotes and descriptions of lending and speculating activities, with various amounts of recklessness or fraud, and it is simply assumed that these anecdotes add up to foundational causation. The report is similar to many of the popular books about the crisis, which are collections of narratives about the various players and agents in the crisis. These books treat every action from developments with the GSEs a half century ago to the last desperate CDO packages in 2007 as "another brick in the wall". The table of contents of these books look something like this:

"A Report on the Failed Harvest"
Chapter 1: Witches Throughout History
Chapter 2: Recent Carelessness about Witches in Our Midst
Chapter 3: Why the Gods are Angry with Local Dissidents
Chapter 4: What the Heretics Have Wrought for All of Us

One assumption at the heart of this bias is that debt can largely be described as a tool for leverage, so that increased use of debt is a sign of recklessness. As with so many issues in finance, this conventional treatment turns reality 180 degrees on its head. It is true that a buildup of debt creates systemic risk. But, debt builds up because debt buyers are seeking safety. Banks aren't leveraged because of demand for high risk capital. They are leveraged because there are trillions of dollars worth of cash that demand risk free low returns in the form of deposits. It wasn't demand for the residual piece of private securitizations that drove that market. It was demand for AAA securities.

We can see this clearly in industries that do not have capital regulations. The relationship between risk and leverage is quite clear. The most leveraged firms are the safest firms - like regulated utilities. They don't issue debt because equity buyers invest in utilities looking for risk. They issue debt because they are in a position to offer debt with very low risk, and the demand for that is great enough that they can earn profits by being a source of fixed income for low risk investors while their equity continues to be fairly low risk. This seems obvious to me. The difference between how debt arises in private markets and how leverage is described in our conventional macro-level narratives is stark.

A small example of this broad sense of question begging is in the FCIC report, on pages 9-10.

One of the first places to see the bad lending practices envelop an entire market
was Cleveland, Ohio. From 1989 to 1999, home prices in Cleveland rose 66%, climbing
from a median of 75,200 to 125,100, while home prices nationally rose about
49% in those same years; at the same time, the city’s unemployment rate, ranging from 5.8% in 1990 to 4.2% in 1999, more or less tracked the broader U.S. pattern.
James Rokakis, the longtime county treasurer of Cuyahoga County, where Cleveland
is located, told the Commission that the region’s housing market was juiced by “flipping
on mega-steroids,” with rings of real estate agents, appraisers, and loan originators
earning fees on each transaction and feeding the securitized loans to Wall Street.
City officials began to hear reports that these activities were being propelled by new
kinds of nontraditional loans that enabled investors to buy properties with little or no
money down and gave homeowners the ability to refinance their houses, regardless
of whether they could afford to repay the loans. Foreclosures shot up in Cuyahoga
County from 3,500 a year in 1995 to 7,000 a year in 2000. Rokakis and other public
officials watched as families who had lived for years in modest residences lost their
homes. After they were gone, many homes were ultimately abandoned, vandalized,
and then stripped bare, as scavengers ripped away their copper pipes and aluminum
siding to sell for scrap.

Pretty damning stuff, huh. Same ol', same ol'. Of course an economy filled with this sort of predation is asking for comeuppance, right?

Here is a graph of home prices among cities that aren't Closed Access or Contagion cities, compared to Cleveland. Cleveland is the thick black line.

You could use the index for Cleveland home prices from 1989 to 2005 as a straight edge. It is difficult to find a single major housing market that was more subdued during this period than Cleveland. This is exactly the effect we should expect from demand side factors where supply isn't a problem - "flipping on mega-steroids" as the report describes it.

Think about it. Take any stochastic market that might be described as a random walk in various ways. Look at the history of that market. There will be times where prices or quantities will be higher or lower, lending will be looser or tighter, foreclosures will be higher or lower. The way this issue is treated, all of those markets are taken as evidence of the predetermined premise and conclusion.

See? In this random market, there was a point in time where there were more foreclosures than there had been at another point in time! Ergo, changing foreclosures caused the thing we are concerned about.

But, shouldn't the fact that nothing happened in Cleveland regarding price levels mean that this example is a mitigating piece of evidence? It would be if we were actually engaged in a review of the evidence. But, we are not. The commission is simply galloping through a set of anecdotes in defense of our priors.